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Coupon rates are generally set at levels that reflect the “going rate of interest” on the day a bond is issued. If the rates were set lower, investors simply would not buy the bonds at the $1,000 par value, so the company could not borrow the money it needed. Thus, bonds generally sell at their par values on the day they are issued, but their prices fluctuate thereafter as interest rates change.

As shown in Figure 4-7, the BellSouth bonds initially sold at par, but then fell below par in 1996 when interest rates rose. The price rose above par in 1997 and 1998 when interest rates fell, but the price fell again in 1999 and 2000 after increases in interest rates. It rose again in 2001 when interest rates fell. The dashed line in Figure 4-7 shows the projected price of the bonds, in the unlikely event that interest rates remain constant from 2001 to 2025. Looking at the actual and projected price history of these bonds, we see (1) the inverse relationship between interest rates and bond values and (2) the fact that bond values approach their par values as their maturity date approaches.

Taken From : Five-Minute MBA – Corporate Finance

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